The Second Circuit revived a lawsuit alleging that several national securities exchanges misled institutional investors about a "two-tier system" giving unfair advantages to high-frequency trading (HFT) firms in exchange for payment. The investors adequately pleaded that the exchanges gave HFT firms trade information and priority over other traders, failed to disclose the negative impact of these practices on order execution, and knowingly created a false appearance of market liquidity. The exchanges were not entitled to absolute immunity as self-regulatory organizations (SROs) because they were not acting in their oversight role in providing the challenged products and services (City of Providence v. Bats Global Markets, Inc., December 19, 2017, Walker, J.).

provide proprietary data feeds giving faster and more detailed information than the consolidated feed, at a price that is cost-prohibitive for ordinary investors and thus discriminatory;

provide "co-location" services in which the exchanges rent space to allow traders to place their computer servers in close physical proximity to the exchanges’ systems, thereby speeding up trades. Again, the investors allege the exchanges charge a price that is cost-prohibitive for ordinary investors;

offer fraudulent and deceptive complex order types to benefit firms at the expense of ordinary investors, including "hide and light" orders that remain hidden until a stock reaches a particular price, at which point the hidden orders emerge and jump the queue ahead of other investors’ orders.

The investors further argued that certain exchanges had not adequately disclosed the full functionality of the complex order types, causing damages to market participants.

The federal district court dismissed the suit, concluding that the exchanges were absolutely immune from plaintiffs’ allegations concerning the proprietary data feeds and complex order types, though not co-location services. Further, the district court concluded that even if the exchanges were not absolutely immune, the plaintiffs had failed to state a claim for a violation of § 10(b) and Rule 10b-5 based on a manipulative scheme.

Long-term investors vs. speculators. As a threshold issue, the three-judge panel concluded that the court had subject matter jurisdiction. The court determined that it was a private action for fraud under Section 10(b) and Rule 10b-5, and did not think that Congress intended for the SEC to adjudicate such claims, as the exchanges had urged was appropriate.

Reviewing the history of the National Market System and Reg NMS, the court said the SEC explicitly emphasized that a national market system must "meet the needs of longer-term investors" versus speculators who hold stock "for a few seconds." Further, the SEC requires exchanges to display bids and offers and distribute core market data on "terms that are fair and reasonable" and "not unreasonably discriminatory."

No absolute immunity. Next, the court took the side of the SEC’s amicus brief and ruled that the exchanges were not entitled to absolute immunity. Noting that immunity is of a "rare and exceptional character" and applies on a case-by-case basis, the court found that the exchanges’ provision of the challenged products and services did not fall within the six contexts for which the court has previously found immunity. The provision of proprietary data feeds, co-location services, and complex order types was "wholly divorced from the exchanges’ role as regulators." Therefore, the exchanges were not "standing in the shoes of the SEC" and immunity did not apply.

Fraud adequately pleaded. Finally, the court concluded that the district court had erred in finding that the plaintiffs had not adequately pleaded manipulative conduct under the Exchange Act. The plaintiffs asserted that the faster feed, co-location, and complex order types artificially affected market activity, allowing HFT firms to "front-run" and drive up prices for other traders.

While the plaintiffs conceded that the exchanges disclosed the existence of proprietary data feeds and co-location services, they asserted that the exchanges did not publicly disclose the full range or cumulative effect that such services would have on the market, the trading public, or the prices of securities. They further contended that the complex order types were not disclosed or were selectively disclosed. The court noted that there was a contested question of fact as to the extent and accuracy of the disclosures.

Accordingly, the court vacated the dismissal and remanded to the district court for further proceedings. Judge Lohier wrote a separate concurring opinion to emphasize that, given the SEC’s specialized experience and filing of an amicus brief, the court should give deference to the agency’s "reasonable and persuasive position."

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